Thanks to sustained high interest rates in the United States, the dollar has been soaring against other currencies. That’s bad news for domestic US producers and good news for those abroad.
These developments hark back to the conditions that led to the 1985 Plaza Accord, which transformed a dominant Japan into a country whose productivity growth lagged behind that of other developed countries. To be sure, Japan was simultaneously facing a technical slowdown and a rapidly aging population, but the Plaza Accord, named for the New York City hotel where it was negotiated, was a crucial factor in its economic stagnation. In hindsight, the Plaza Accord did deliver some of the desired outcomes, at least for the US, by raising the value of the yen and curtailing Japan’s decades-long growth spurt.
And the negative consequences for Japan were partly the result of the Bank of Japan’s overly hawkish monetary policy. It is understandable, then, that some politicians are considering creating a Plaza Accord 2.0. But this time, the US is confronting China as well as Japan, and negotiating with China, its great-power rival, would be more politically challenging than negotiating with Japan, a staunch US ally, in the 1980s.
But before policymakers make up their minds, they need to consider why the dollar and the yen, now coupled with the renminbi, are in a situation that recalls the 1980s. The answer lies in flexible exchange rates, the basic mechanism that led to currency arrangements like the Plaza Accord.
The cross-border effects of monetary policy depend on whether exchange rates are fixed or flexible. Under a fixed exchange-rate regime, a country’s monetary expansion acts as a stimulus for itself and its trading partners. But when the exchange rate is flexible, a country’s monetary expansion acts as a stimulus only for itself, and has a contractionary effect on its trading partners.
In the modern financial system, the exchange rate between two currencies is determined by the existing assets denominated in each. Just as the relative price of apples and oranges is affected by their quantities in the market, monetary expansion that increases assets denominated in a country’s currency tends to depreciate the exchange rate. Conversely, monetary expansion by its partner country tends to cause that currency’s exchange rate to appreciate.
Exchange-rate interventions may be temporarily effective but cannot have enduring effects unless supported by appropriate monetary policy. To strengthen the value of the yen in 1985, the Plaza Accord had to be supported by contractionary monetary policy in Japan and relatively expansionary monetary policy in the US. Unfortunately, the BOJ kept monetary policy too tight, and Japan was mired in deflation and recession for two decades. The interdependence between the US and Japan in this situation can be viewed as a game, in which each country has two basic instruments: its own monetary expansion and monetary expansion by its partner.
These instruments determine the exchange rate, but are highly dependent on each other – like the relative price of apples and oranges. Suppose each country in this scenario has its own desired level of inflation. One country may aim for slightly higher inflation because, as indicated by the Phillips curve, it is associated with lower unemployment, and also because, as US Treasury Secretary Janet L Yellen has argued, a “high-pressure economy” could boost productivity.
Fortunately, in this simplified game, each country’s monetary policy is chosen depending on the other’s policy. This interdependence would generate desired inflation, which in turn would produce ideal levels of unemployment and technological progress. In other words, monetary policy should target optimum inflation in each country, while accounting for the effect of its partner country’s monetary policy.
For example, in response to US monetary expansion after the Lehman Brothers collapse in 2008, Japan should have launched substantial monetary expansion; and it should respond to interest-rate hikes in the US since the Covid-19 pandemic with its own moderate rate increases. But the benefits of this approach to pursuing each country’s best optimal inflation rate under a flexible exchange-rate regime would be lost if countries have balance-of-payments or fiscal-consolidation objectives.
This implies that, under flexible exchange rates, monetary authorities around the world could solve the problems of inflation, unemployment, and technological progress at the same time. Instead of determining appropriate exchange-rate levels, the Plaza Accord should have provided a venue for this monetary-policy game. Today’s policymakers must concentrate on the benefits provided by flexible exchange rates. A strong dollar was necessary to tame inflation in the US after the Covid-19 crisis, and initially provided a boon for business in Japan. But there are already signs that the yen is too weak: a steep decline in outbound travel, higher spending on energy imports, and the threat of future inflation. To remedy the situation, the BOJ should quickly adjust short-term as well as long-term interest rates accordingly. Copyright: Project Syndicate, 2024
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